As the stock market nears the end of 2022, investors and traders must sort through many conflicting clues and indicators. Uppermost in mind right now is the Federal Reserve. The Fed signaled that it would not raise rates by as much as had been feared (a half-point move is now expected at the December meeting, versus a three-quarter point move).
If a heralded Santa Claus rally appears this year for U.S. stocks, the Standard & Poor’s 500
could rise above 4,000 again and stay there, at least for a while. Unfortunately, the higher the index goes, the greater the likelihood it will top out and reverse. Although it’s impossible to pick the exact top or bottom, there are ways to judge whether the market has moved too far and too fast and is in the danger zone (overbought).
Here are four clues you can use to identify market tops:
1. RSI (Relative Strength Index): One of the most reliable indicators to identify market tops (and bottoms) is RSI, a favorite of many traders. On a daily chart, if RSI is at or near 70, it is considered overbought: the odds are good that the S&P 500 will reverse direction. Conversely, if RSI is at or below 30, it is considered oversold, and the odds favor a move to the upside.
When RSI gives a signal, pay attention. Although there are no magic answers, RSI gives timely clues as to what the market is telling us about the future. Yet like any indicator, RSI is not perfect. An index or a stock may stay overbought or oversold for long time periods. Therefore, just because RSI hits 70 (overbought) or drops below 30 (oversold), it does not mean a reversal is imminent.
Right now, RSI has been hovering between 50 and 60 for the S&P 500. This suggests that while the index is overbought, it is not at extreme levels.
2. Failed rallies: A time-tested method for identifying market tops are failed rallies. These rallies reverse a direction, but are unable to move higher. For example, if the S&P 500 is unable to stay above 4,000, that would be a negative sign.
In addition, pay attention to trading volume. Volume moves markets: a low-volume rally is at greater risk of reversing direction than a high-volume one.
3. Broad participation: If just a few high-capitalization stocks are causing the market to rise, then a rally is likely to run out of steam. For a rally to be real, many stocks need to participate.
4. Resistance levels: Resistance is the price level at which a stock price has stopped rising and sellers take temporary control. Some traders refer to this as a “ceiling.”
Resistance for the S&P 500, for example, is at 4,000 now. If the index crosses 4,000 and stays above it, then 4,000 becomes the new support level. Buying demand has then become strong enough to prevent sellers from driving prices lower.
It will take a strong effort for the index to move through 4,000, after trying and failing multiple times. If it continues to fail, that’s a negative sign.
Michael Sincere (michaelsincere.com) is the author of “Understanding Options” and “Understanding Stocks.” His latest book, “How to Profit in the Stock Market” (McGraw Hill, 2022), explores bull -and bear market investing strategies.